“Imagine a scenario in which the federal government helps households pursue the American dream with ultra-loose credit, only to see prices skyrocket and families take on loads of debt they can’t repay. Yes, it sounds like the housing market of a decade ago, but some say it is also the challenge of today’s higher-education system…

…The federal government has boosted aid to families in recent decades to make college more affordable. A new study from the New York Federal Reserve faults these policies for enabling college institutions to aggressively raise tuitions.”, Josh Mitchell, “Federal Aid’s Role in Driving Up Tuitions Gains Credence”, The Wall Street Journal, August 4, 2015

Federal Aid’s Role in Driving Up Tuitions Gains Credence

View long held by conservatives is being adopted by more mainstream economists; New York Fed study faults government aid for letting colleges boost prices

A tour group at the Sterling Memorial Library on Yale University’s campus in New Haven, Conn., earlier this summer. Photo: Craig Warga/Bloomberg News

By Josh Mitchell

Imagine a scenario in which the federal government helps households pursue the American dream with ultra-loose credit, only to see prices skyrocket and families take on loads of debt they can’t repay.

Yes, it sounds like the housing market of a decade ago, but some say it is also the challenge of today’s higher-education system.

The federal government has boosted aid to families in recent decades to make college more affordable. A new study from the New York Federal Reserve faults these policies for enabling college institutions to aggressively raise tuitions.

The implication is the federal government is fueling a vicious cycle of higher prices and government aid that ultimately could cost taxpayers and price some Americans out of higher education, similar to what some economists contend happened with the housing bubble.

Now, more mainstream economists and academics are adopting that view, or at least some variation. And while college institutions reject the notion that they game the federal student-aid system to jack up prices, many higher-education officials concede there is a pricing problem, and changes are needed.

“There’s widespread concern among policy makers and college officials that it has become too easy for students to borrow large amounts of money without necessarily appreciating what they are getting into,” said Terry Hartle of the American Council on Education, a trade group representing college and university presidents.

The government’s student-credit spigot burst open in recent decades as Americans sought a leg up in an increasingly sophisticated economy, and accelerated during the last recession. Annual student-loan disbursements—which include some private loans but come mostly from the federal government—more than doubled between 2001 and 2012 to $120 billion, according to the New York Fed’s David O. Lucca, Taylor Nadauld and Karen Shen.

And it’s not just that more people went to college; the amounts borrowed also grew sharply. During that time, the average loan per recipient rose 58%, after inflation, to $5,777 a year.

Federal student loans allow Americans to borrow at below-market rates with scant scrutiny of their credit and no assessment of their ability to repay. Meanwhile, federal Pell grants, which help low-income college students and don’t need to be repaid, more than tripled to more than $30 billion a year between 2001 and 2012. Education tax credits roughly quadrupled to about $20 billion a year.

George Washington University’s commencement on the National Mall in Washington in May. Photo: Alex Brandon/Associated Press

The cost of getting a degree similarly exploded. From 2000 to 2014, consumers’ out-of-pocket costs for college and graduate-school tuition rose 6% a year, on average, according to the Labor Department’s consumer-price index. By comparison, medical-care inflation looks meek at an average 3.8%. Overall consumer prices climbed 2.4% a year.

Correlation or causation? The study looked at schools that derive a great share of revenue from student aid with those that derive a small share from aid. It compared tuition growth at those schools during the past decade with several moves made by Congress to increase caps on individual Pell grants and undergraduate subsidized loans, which are based on financial need and have better terms than unsubsidized loans.

The study found that, on average, for a $1 increase in the subsidized-loan cap, tuitions rose by as much as 65 cents. For Pell grants, it translated to 55 cents on the dollar. The study pinpoints private schools—both nonprofit and for-profit—as bigger offenders than public ones.

To be sure, other studies over the years have yielded mixed results, with some finding a strong causal link between federal aid and tuition and others finding none.

A 2012 study by researchers Stephanie Riegg Cellini of George Washington University and Claudia Goldin of Harvard University found evidence that federal grants led to higher prices at for-profit colleges.

Some critics contend the New York Fed study is flawed because it looks at colleges’ sticker prices, which are seldom what students actually pay after grants and scholarships are factored in. Net prices —reflecting students’ out-of-pocket costs—have increased more slowly in recent years than sticker prices. Mr. Hartle of the American Council on Education blames tuition growth largely on declining state government subsidies for higher education, which mostly affects public universities.

One thing the latest research doesn’t address is the effect of student aid on graduate-school tuitions, which have disproportionately driven the surge in student borrowing. And grad school is perhaps where the market is most distorted by federal policies.

The federal government limits how much undergrads can borrow—up to $57,500 total—but doesn’t for grad students, who can borrow to cover any amount their schools charges through a decade-old program known as Grad PLUS. Economists say that has given institutions unprecedented pricing power. Debt-forgiveness programs also could be desensitizing grad students to high prices.

Andrew Gillen, who has studied and believes in the Bennett Hypothesis, said more work needs to be done to analyze whether federal aid is boosting grad-school costs.

Mr. Gillen—an academic at the Charles Koch Foundation, a nonprofit founded by the conservative billionaire that donates widely to U.S. colleges—said there is one early sign that it is: In the seven years before Grad PLUS, college tuitions were rising faster than grad-school costs. In the seven years after, the reverse occurred.